Friday, November 21, 2008

What's So Bad About Deflation?

Economists are starting to freak out about the possibility of price deflation. The October CPI showed a 1% drop in price level from the previous month. This, in itself, is no big deal and might give consumers a little confidence to spend a bit more, but it can become problematic if it persists and starts seeping into expectations. What we are worried about now is exactly this - expected deflation. But why is this a problem?

When businesses expect prices to be lower in the future, they pull back on investment and output and this leads to lowering employment and (where possible) wages. This will, of course, decrease demand which will put further downward pressure on prices. This becomes a downward spiral and the very scary part is that it is not clear how to make it stop. Generally, to manage inflation the Fed changes its target federal funds rate and if it wants to spark inflation they lower the federal funds rate. But right now the Fed is not really able to do this. Though the target rate is at 1% the demand for treasuries is so high that the effective rate on T-bills is already close to zero. In essence, what the Fed wants is for people to take dollars and use them and is offering a very low price of borrowing, but right now people are so freaked out that they don't want to borrow at any price, in fact they are close to PAYING the US government to keep their dollars safe. Yikes.

There is another aspect of deflation that fuels the spiral: loans (like mortgages) are generally in nominal terms so deflation actually increases the real interest rates on outstanding debt. In other words you give up more consumption of everything else. This leads to lower consumption as well.

So what level of inflation is good? Well, most central bankers like the 1 to 2 percent range.

1 comment:

Our economy shouldn't be regulated with a Big Government owned bank. Banks like inflation it encourages people to burrow. so if the economy has been encouraging people to live pay check to pay check. well we know what will happen when they lose their job!! lol economy fails and fails rather hard. silly people!!

what we need to do. have deflation, encourage people to save! that way they lose their job they can live for a while before dieing or getting government aid.

But i guess it doesn't matter.we have had inflation for the past 100 years. now hopefully we will have deflation and people will save maybe we will have deflation for the next 100 years! it is a 100 year cycle! two generations.

but what happens if we had deflation? people save. economy goes down :(. well wait. the prices were adjusted for inflation! so all really what happens is the prices get adjusted for deflation. so it might be 2 years of bad economy while prices are adjusting. then people save. everyone saves so no one needs loans. banks instead of making money loaning money they invest in the stock market. prices in the stock market go really high! or well people would choose the best investment. i feel it the stock market. but the banks may find something. so it should be cycling deflation and inflation. if people mad money in the stock market because everyone puts money there because banks lower savings rates. demand for stocks go up so stock prices go up.

Inflation and deflation don't matter. but i feel if everyone saved more the economy would be more stable. no one would trade on margin! it would be too expensive. maybe The big investment banks would fail if there was deflation. but i don't really like the idea of some one making money not doing anything really productive. they invest. they don't produce any goods. they should fail.

Well this if from a guy who has assets to expenses ratio of about 10. so i could live how i am living for ten years before i need to be productive.

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